Question 1

Apex Insurance Company wrote a large number of property insurance policies in an area where earthquake losses could occur. When the president of Apex was asked if she feared that a severe earthquake might put the company out of business, she responded, "Not a chance. We transferred most of that risk to other insurance companies." An arrangement by which an insurer that initially writes insurance transfers to another insurer part or all of the potential losses associated with such insurance is called

Accepted Answer

The arrangement described in the scenario is called reinsurance. Reinsurance is when an insurance company transfers part or all of its potential losses to another insurer. This helps the initial insurer limit its exposure to risk and protect itself in the event of a significant loss.

Question 2

Gina would like to buy a house. She will pay 10 percent of the cost of the house as a down payment and borrow the other 90 percent from a mortgage lender. The home will serve as collateral for the loan. The lender will not make the loan to Gina unless the home is insured. Using insurance to secure the collateral for a loan illustrates which of the following benefits of insurance to society?

Accepted Answer

Insurance helps to enhance credit by providing lenders with the assurance that their collateral is protected in the event of a loss. In this case, the lender requires insurance on the home to ensure that they will be able to recoup their losses if Gina defaults on the loan.

Question 3

According to the law of large numbers, what should happen as an insurance company increases the number of loss exposures that it insures?

Accepted Answer

The law of large numbers states that as the number of loss exposures increases, the difference between actual and expected results should decrease. This is because with a larger sample size, the actual results are more likely to approach the expected results, reducing the variability in the underwriting results.

Question 4

Which of the following statements regarding private insurance and government insurance is (are) true?
I.Private insurance programs include life and health insurance and property and liability insurance.
II.Social insurance programs are government insurance programs that are voluntary and financed entirely by contributions from covered employers.

Accepted Answer

Private insurance programs include life and health insurance and property and liability insurance, which is mentioned in statement I. However, statement II is incorrect as social insurance programs are actually government insurance programs that are mandatory and financed through payroll taxes, not voluntary and not solely financed by covered employers.

Question 5

XYZ Insurance Company writes coverage for most perils which can damage property. XYZ, however, does not write flood insurance on property located in flood plains. Which requirement of an ideally insurable risk might be violated if XYZ wrote flood insurance on property located in flood plains?

Accepted Answer

The loss from flooding in flood plains can be catastrophic due to the high likelihood of many properties being affected simultaneously, making it challenging for insurance companies to spread the risk.

Question 6

Insurance companies collect premiums in advance. Since the premiums collected are not needed to pay losses and expenses immediately, the funds can be loaned to business firms. Because of this fact, insurance benefits society by

Accepted Answer

Insurance companies invest the premiums collected in various investment vehicles, and those investments help in the development and growth of the economy. This process provides a ready source of funds for businesses to borrow, invest and expand.

Question 7

Which of the following statements regarding insurance and hedging is (are) true?
I.Insurance involves the transfer of an insurable risk while hedging handles risk that is typically uninsurable.
II.Insurance transactions can reduce objective risk, while hedging typically involves only risk transfer and not risk reduction.

Accepted Answer

I. Insurance is indeed about transferring insurable risks (like property damage, health issues, etc.) to an insurer, while hedging is used for managing financial risks (like currency fluctuations, interest rates, etc.) that are generally not insurable through traditional insurance products.II. Insurance can reduce objective risk by pooling and thereby diversifying risk among many policyholders. Hedging, on the other hand, involves transferring the risk to another party willing to take on that risk, often without reducing the actual underlying risk itself.

Question 8

One branch of government insurance programs has a number of distinguishing characteristics. These programs are compulsory, they are financed by mandatory contributions rather than general tax revenues, and benefits are weighted in favor of low-income groups. These government insurance programs are called

Accepted Answer

Social insurance programs are compulsory, funded by mandatory contributions, and provide benefits that are weighted towards low-income groups. Welfare programs are not necessarily compulsory and are often funded by general tax revenues. Casualty insurance programs provide coverage for specific risks, such as car accidents or home damage. Private insurance programs are voluntary and not run by the government.

Question 9

LMN Insurance sells homeowners insurance. The LMN homeowners policy combines property and casualty insurance in the same contract. Insurance policies combining property and casualty coverage in the same contract are called

Accepted Answer

Insurance policies combining property and casualty coverage in the same contract are called multiple-line policies. Mono-line policies only cover one type of insurance, multi-year policies have a contract term longer than one year, and manuscript policies are customized policies specifically tailored to the insured's needs.

Question 10

JKL Insurance Company estimates that 14 out of every 100 homeowners it insures will file a claim each year. Last year, JKL insured 200 homeowners. According to the law of large numbers, what should happen if JKL insures 2,000 homeowners this year?

Accepted Answer

According to the law of large numbers, as the sample size (in this case, the number of homeowners insured by JKL) increases, the actual results should more closely approach the expected results (in this case, the estimated 14% of homeowners filing a claim each year). Therefore, as JKL insures more homeowners (from 200 to 2,000), the actual number of claims filed should be more similar to the expected number of claims (14% of 2,000 = 280 claims) than it was when they insured fewer homeowners.

Question 11

ABC Insurance Company calculated the amount that it expected to pay in claims for each policy sold. Rather than selling the insurance for the amount it expected to pay in claims, ABC added an allowance to cover the cost of doing business, including commissions, taxes, and acquisition expenses. This allowance is called a(n)

Accepted Answer

Adding an allowance to cover the cost of doing business, including commissions, taxes, and acquisition expenses is called expense loading. This allowance is added to the amount expected to be paid in claims to determine the total premium charged to the policyholder.

Question 12

All of the following are benefits to society that result from insurance EXCEPT

Accepted Answer

Insurance helps to mitigate risk and provide financial protection in the event of loss, which can reduce worry and fear and provide indemnification for loss. Insurance also may offer resources for loss prevention. However, insurance typically does not eliminate moral hazard, which refers to the potential for insured individuals to take excessive risks or act in a careless manner because they know they are protected by insurance.

Question 13

Adverse selection occurs

Accepted Answer

Adverse selection occurs when applicants with a higher-than-average chance of loss seek insurance at standard rates. This leads to the insurance company paying out more in claims than they anticipated, resulting in financial losses.

Question 14

Which of the following statements about the insurance industry as a source of investment funds is (are) true?
I.These funds result in a lower cost of capital than would exist in the absence of insurance.
II.These funds tend to promote economic growth and full employment.

Accepted Answer

I. Insurance companies are a major source of investment funds, as they collect premium payments from policyholders and invest those funds into various financial instruments. This lowers the cost of capital for companies that need to raise funds for investments or expansion, as insurance funds are often a cheaper source of capital than other forms such as bank loans or issuing bonds.

II. Furthermore, insurance funds can promote economic growth and full employment by providing capital for new businesses or infrastructure projects, creating jobs and stimulating economic activity. This is because insurance companies invest in a variety of sectors, including real estate, infrastructure, technology, and emerging markets, which can have a positive impact on the overall economy.

Question 15

Which of the following statements concerning social insurance benefits is (are) correct?
I.Social insurance benefits are heavily weighted in favor of upper-income groups because of their higher earnings.
II.Social insurance benefits are financed entirely or in part by mandatory contributions by covered employers and employees, and not by general revenues of the government.

Accepted Answer

Statement II is correct while Statement I is incorrect. Social insurance benefits are financed through mandatory contributions by covered employers and employees, which means that everyone who pays into the system is eligible for benefits regardless of their income level. However, some argue that certain programs like Social Security may disproportionately benefit higher-income individuals due to the way benefits are calculated.

Question 16

A group of farmers agreed that if any farmer suffered a property loss, the loss would be spread over the entire group. In this way, each farmer is responsible for the average loss of the group rather than the actual loss that each farmer sustained. Which characteristic of insurance is embodied in this agreement?

Accepted Answer

The characteristic of insurance that is embodied in this agreement is pooling of losses. The farmers are agreeing to combine their potential losses and share the risks equally among themselves. This spreads the risk of losses and reduces the financial impact on any one individual.

Question 17

All of the following are social costs associated with insurance EXCEPT

Accepted Answer

Increased cost of capital is not a social cost associated with insurance. The other three options are social costs associated with insurance, as they increase overall costs and decrease efficiency in the insurance market.

Question 18

Ashley opened an all-you-can-eat buffet restaurant. The price per-person was based on what Ashley believed an average restaurant patron would consume. The restaurant began to lose money. Ashley concluded that her patrons had "above average" appetites, and were attracted to her restaurant because they could eat as much as they wanted while being charged an average price. A similar phenomenon exists in insurance markets. This problem is called

Accepted Answer

The situation described is an example of adverse selection, where higher-risk individuals are more likely to enroll in insurance plans, leading to higher overall costs for the insurer. In Ashley's case, patrons with larger appetites were more likely to choose her restaurant, leading to higher costs for the restaurant.

Question 19

Which of the following is a form of casualty insurance?

Accepted Answer

The answer of Which of the following is a form...

Question 20

ABC Appliance offers a warranty requiring an annual fee. The warranty may be purchased at the time of sale or at any time within the first year after the appliance was purchased. The warranty fee after the date of purchase is twice the time-of-purchase fee. When asked why the fee was higher after the date of purchase, ABC's president said, "Buying a warranty is voluntary. We've noted that those who buy the warranty after the purchase date have a greater need for service." Charging the same rate or a lower rate after the date of purchase would expose ABC to what problem that also impacts private insurers?

Accepted Answer

Adverse selection is the problem faced by private insurers where those who are more likely to make claims are more likely to purchase insurance. In this case, ABC Appliance is charging a higher fee to those who purchase the warranty after the date of purchase because they believe these customers have a greater need for service. This is an indication of adverse selection, as those who are more likely to require service are more likely to purchase the warranty at a later date. Charging the same or lower rate would further encourage adverse selection and potentially lead to a higher number of claims, similar to what private insurers may experience if they do not properly assess risk before setting premiums.

Quiz 2: Insurance and Risk